Facebook, One Year Later: What Really Happened in the Biggest IPO Flop Ever

After Facebook's disastrous debut, the preferred clients of big banks walked away with huge profits. How? Public documents and interviews with dozens of investment bankers and research analysts reveal that the Street caught wind of something the public didn't. The social network and the banks told half the story. Here is the other half.

Uma Swaminathan tuned the television set in the living room of her ranch style home in the suburbs of East Brunswick, N.J. to CNBC. It was 9:00 a.m. on May 18, 2012, a day the retired schoolteacher thought might make her rich. She logged onto her Vanguard brokerage account on her computer and placed an order for 5,000 shares of Facebook at $42 a share.

On TV, wearing his trademark hoodie, 28-year-old Mark Zuckerberg, creator of the world's largest social networking site, stood in the courtyard of Facebook headquarters in Menlo Park, California. A crowd of eager Facebook employees held up company license plates and posters for the cameras. They'd stayed up all night at an employee "hack-a-thon" to celebrate the big day when Facebook was finally going public, in what might have been the most anticipated initial public offering in history. The boyish, blue-eyed Zuckerberg grinned, standing next to Bob Greifeld, chief executive of Nasdaq-OMX Stock Market, Inc., the largest electronic stock exchange in the United States.

With short hair, brown skin, and few wrinkles, Swaminathan looks much younger than her 68 years. She spent most of adult life as a suburban mom, making tofu for her daughter's friends at theater rehearsals, taking her three sons to soccer practice and Boy Scouts, and volunteering in the local community. She served a term as president of the Indian American Association of New Jersey.

Her interest in the stock market didn't develop until her husband died about 13 years ago. Her four children had already moved out to attend college or to pursue their careers. Swaminathan was left with her late husband's 401(k) retirement account, when she started dabbling in the market, investing in stable companies like Microsoft. Not long after, she began to follow the news coverage of initial public offerings (IPOs) -- when private companies enter the public market -- and came to know of the phenomenon known as the first day "pop." On the day that companies would debut on the stock market, the price would tend to shoot up before stabilizing. A year earlier, she watched as social networking site LinkedIn's stock price closed up 109 percent on its opening day.

She'd never placed such a big bet on just one stock, but she felt a personal connection to Facebook. She had been using the site to connect with family and friends since 2009, and almost everyone she knew had an account.

Now, as she watched the TV in eager anticipation, millions of shares were going to leave the hands of private investors and start trading, giving anyone with enough money a chance to own a slice of the social network giant. Silence descended as Zuckerberg came forward to deliver his speech: "I just want to say a few things, and then we'll ring this bell and we'll get back to work. Right now this all seems like a big deal. Going public is an important milestone in our history. But here's the thing: our mission isn't to be a public company. Our mission is to make the world more open and connected..."

Finally he reached the moment so many were waiting for: "So let's do this!" And the opening bell sounded as he signed the digital screen on the podium before him: "To a more open and connected world," he wrote. His handwritten message instantaneously appeared in Times Square just above the giant illuminated NASDAQ exchange ticker.

Facebook shares hit the market at an opening price of $38. Minutes later, Swaminathan's online order was executed, and the retired schoolteacher had just spent approximately half her life savings.

I: THE OFFERING

For Mark Zuckerberg, selling Facebook shares on the public market had a clear downside. Besides the headache of releasing a company's financial details to the public, he worried that increased scrutiny and push for profits would compromise Facebook's mission.

But like any growth-stage company, Facebook needed money, and private companies face restrictions on how much stock they can issue for cash. In early 2011, Goldman Sachs helped Facebook conjure IPO-type money without an actual IPO by creating a special investment product to sell its private shares to Goldman's wealthiest clients. But when the New York Times exposed the plan, the SEC began to investigate the transaction. Soon after, Zuckerberg decided to take the company public. In late 2011, the Wall Street Journalreported that Facebook was anticipating an IPO valuation of $100 billion -- nearly four times more than Google's market cap when it went public in 2004.

On February 1, 2012, Facebook filed its Form S-1 -- effectively a birth certificate for publicly traded companies -- containing everything an investor needs to know before buying shares at an IPO, including basic financial information and the business model. Facebook's S-1 showed that the company was primarily in the display-advertising business, with a net profit of $1 billion in 2011 from total revenue of $3.7 billion.

The S-1 is especially meaningful to investment banks. Facebook listed its underwriters -- the banks picked to buy and sell shares on the IPO -- near the front of the document, from left to right, in order of responsibility, with Morgan Stanley in the coveted "left lead" position.

This put Facebook's IPO in the hands of one of Silicon Valley's most celebrated bankers: Michael Grimes, co-head of global technology banking at Morgan Stanley's Menlo Park office, located just a few miles north of Facebook's headquarters.

II: THE BANK

Michael Grimes, the son of a mapmaker, is a lifelong Californian with a bachelor's in computer engineering from UC Berkeley. A titan in the world of tech IPOs, his status grew not only from expertise in taking small and large digital companies public, but also from his myth-making showmanship. To win Ancestry.com's IPO, he created his own family tree and wore a green Hermes tie with leaves to signify the company logo. To get a Hewlett Packard acquisition, he waited outside an executive's office for hours just to make a pitch.

With Grimes and the investment bank prepping the offering and building demand for shares, it fell to another Morgan Stanley employee, Scott Devitt, to tell outside money managers whether they should buy Facebook stock. As the head of Morgan Stanley's Internet equity research team, Devitt makes a 12-month target price for stocks and provides a rating -- buy, hold, or sell -- for hedge funds like Citadel and large, storied institutional investors like Fidelity. Devitt's agreement with his clients guarantees an independent analysis of company performance -- even if Morgan Stanley is leading the IPO. (Devitt advised clients on whether to buy companies like LinkedIn, Zynga and Pandora while Grimes orchestrated their IPOs.)

The stark division between these two functions of a bank is known as a "Chinese Wall." It forbids investment bankers, like Grimes, from influencing research analysts, like Devitt. Morgan Stanley and other brokerage firms were slammed with fines for repeatedly breaching the "Wall" during the dot-com boom. In the aftermath of the Facebook IPO, the bank would find itself under the spotlight yet again for allegedly sharing key, private information with wealthy clients.

In Facebook's case, the trouble began with a simple revision.

III: THE REVISION

A roadshow -- a city-by-city promotional tour where executives drum up support for their IPO before large investors -- is typically a lackluster affair. Facebook's was more like a Hollywood party.

On May 7, 11 days before the IPO, Facebook management -- CEO Mark Zuckerberg, COO Sheryl Sandberg, and CFO David Ebersman -- stepped out of a black SUV in front of the Sheraton Hotel in midtown Manhattan for their first meeting with investors. A crowd of paparazzi greeted them, and a long line of onlookers wound around the hotel building. Inside the meeting, Facebook played a video introducing the business model to special clients of its underwriting banks.

Although an IPO roadshow is supposed to be an untarnished hype-machine for a company's prospects, back in California, those prospects were hurting. Facebook's new internal forecasts showed revenue growing slower than expected. The reason: Users were flocking to smartphones faster than the company could serve mobile ads.

On the first day of what may have been the most watched IPO roadshow in memory, Ebersman confessed to Morgan Stanley that Facebook had cut revenue projections -- a nearly unprecedented last-minute correction in an IPO of its scale. Even if the changes were small, statistically, in IPO showbiz statistics run second to momentum, and nothing kills momentum like a poorly timed downward revision.

Facebook and Morgan Stanley knew they had to make a public disclosure. But what to disclose? The law requires companies to share all information that would likely influence an investor's decision to buy stock. Plus, Morgan Stanley's research team was still advising clients based on figures that Facebook now considered wrong. With less than a week before the IPO, they came up with a solution that they thought would spare Facebook a modicum of embarrassment -- but would have fateful consequences for Morgan Stanley and investors:

• First, Facebook would file an amendment to its public birth certificate, the S-1, to include information about mobile usage cutting into revenue.

• Second, the company would call research analysts with much more specific information about the company's weakening projections.

IV: THE AMENDMENT

When a company makes an amendment to its S-1, the entire document can be filed again, without track-changes or highlights to specify the changes. When Facebook filed its "Amendment No. 6 to Form S-1" to disclose its ongoing challenge to serve ads to mobile users, changes were embedded on three pages of the 170-page document.

On page 14 and 17, the company said that its users were growing faster than ads due to the increased use of mobile phones and product decisions that allowed fewer ads per page. On page 57, Facebook said the mobile trend discussed elsewhere in the document had continued in the second quarter, due to users shifting from computers to phones. None of the changes suggested any major revision to Facebook's financial outlook.

Facebook's lowered revenue estimates did not appear in the S-1, nor was there any precedent requiring these numbers to be included. Even the most sophisticated retail investors, armed with a software bot that could comb the new S-1 for updates, could not have read what research analysts at Morgan Stanley, JP Morgan, Goldman Sachs, Citigroup, and many other investment banks would learn later that evening: That Facebook, already projected to trade at high multiples given its earnings figures, was slashing its annual projections.

V: THE CALL

Before an IPO of Facebook's size, research analysts and large investors play a massive multi-billion-dollar game of "Telephone," because analysts at underwriting firms are banned from publishing or emailing research about a new public company until 40 days after the IPO. The rule is designed to protect retail investors from taking analysts' notoriously bullish research too seriously. But it has an unintended side effect: Research analysts can pass on exclusive, last-minute information to institutional clients without a paper trail.

And Facebook's last-minute revelation was about to launch a historic game of "Telephone."

After the company's surprising eleventh-hour amendment, the unenviable job of explaining Facebook's revisions to the research analysts fell to Cipora Herman, Facebook's vice president of finance. On May 9, Herman and Michael Grimes huddled in a Philadelphia hotel for a rehearsal session. He played the part of an analyst, while she played herself. They practiced until the amended S-1 was officially made public on the SEC website, at exactly 5:03pm.

Before her first call to Scott Devitt at Morgan Stanley, Grimes left the room to avoid the appearance of breaking the law that bans investment bankers from influencing analysts. "I was far down the hall so I wouldn't hear anything," he testified in a Massachusetts suit brought against Morgan Stanley. "I took extra precaution to do that, and sat on the floor."

But Herman had a script in Grimes' handwriting detailing Facebook's new second-quarter revenue estimates:

"I wanted to make sure you saw the disclosure we made in our amended filing. The upshot of this is that we believe we are going to come in the lower end of our $1.1 to $1.2 bn range for Q2 based upon the trends we described in the disclosure."

The script also showed that Herman had added Facebook's year-end estimates:

"Trend/headwinds over the next six to nine months as this run through the rest of the year, this could be 3 to 3 and a half percent off the 2012 $5 billion target."

Herman's first three calls were to the research desks of Morgan Stanley, JPMorgan, and Goldman Sachs, and after their conversations, all three banks cut their estimates of Facebook's annual revenue by between 3.01% and 3.33% --
perfectly aligned with Herman's notes, as the following charts from court documents show:

The news spread -- from research analysts to their preferred clients -- that Facebook was slashing revenue estimates in the middle of the roadshow. Morgan Stanley, JP Morgan, and Goldman Sachs had effectively sounded alarm bells on Wall Street. Even analysts who hadn't yet made a single call about Facebook's new figures were being inundated with questions. "Our clients were asking us to confirm what they had heard, so we had to tell them what we knew," said a research analyst at one of the other underwriting firms.

Many large investors sensed a rare opportunity: With its revenue projections falling at such a peculiar time, the conditions could be perfect to place a massive bet against Facebook stock.

VI: THE BET

A week before the IPO, confusion reigned in the financial press.

On May 11, Bloomberg reported that demand for Facebook's stock among institutional investors was much lower than expected. But on the same day, Reuters had a conflicting report: Facebook was already oversubscribed, and one large unnamed institutional investor was calling around syndicate desks trying to get more shares.

While retail investors clamored for Facebook shares, some large investors were planning a massive short -- essentially betting against the stock's buyers. Scott Sweet, senior managing partner of Tampa-based research firm IPO Boutique, received calls from hedge fund clients saying they heard from research analysts at underwriting banks that Facebook's mobile trend was behind its lowered earnings estimates. One multi-billion dollar hedge fund client told Sweet that he planned to short the stock as a result. (Sweet didn't name the investor due to a confidentiality agreement he has with clients.)

"The consensus among hedge funds on the West Coast was to short the stock on day one," said one institutional investor at a medium-sized hedge fund specializing in technology stocks. "The call we received from JP Morgan about earnings being lighter than expected gave us even more conviction in our short." Hedge fund analysts at his firm were receiving calls from their personal brokers days before the IPO, hawking an allegedly rare chance to get shares of Facebook stock. "That never happens," the hedge fund investor said. "Supply was definitely exceeding demand."

But despite the growing consensus among some large investors that Facebook was overpriced, on May 15, three days before Facebook's market debut, the underwriting banks increased the IPO range from $28-$35 to $35-$38, citing heavy demand. A day later, they increased supply to more than 420 million shares.

The new share and price allocation placed Facebook's valuation at the iconic $100 billion mark.

VII: THE GLITCH

Back in her home, Swaminathan didn't know about the reduced revenue estimates or about the vast number of hedge funds that were planning to short Facebook. After the opening bell ceremony neared its end at 9:30 a.m., she was still watching CNBC waiting for the stock to begin its scheduled trading at 11:00 a.m. "We are witnessing a lot of American wealth getting generated as we speak," said a CNBC reporter. "After years of people taking risks, dealing with uncertainty, unknowns, rivals, this is the pay-off."

"Awaiting Facebook's opening trade" showed in a breaking news box on the bottom of the screen, while an unchanged $38 opening price appeared on a split screen in anticipation of 11:00 a.m. Minutes later, Swaminathan, eager for the stock to open, called her son, who lives in New York City, to inform him about the 5,000 shares she had ordered. She had placed a buy limit order, a conditional transaction to purchase shares at a specified price -- $42 in her case -- or lower.

Her son, who studied finance at UC Berkeley, was livid. "Cancel the order immediately," he told his mother. "Cancel it! Cancel it!" Around 9:45 a.m., she hit the icon on her trading screen to cancel the order and then resumed watching TV. At 11:00 a.m., CNBC announced that Facebook's opening was delayed until 11:05 a.m. In all the times she had seen IPOs on television, Swaminathan had never witnessed a market delay on the opening day. Something is wrong, she thought.

She turned her attention to her computer screen only to realize that there was no sign of her having voided the order. She kept refreshing the page in hopes of seeing the notification. When no cancellation report appeared, she called her stockbroker at Vanguard. "What's going on?" she asked.

If the cancel order was placed, then it's probably cancelled, the broker told her. She got off the phone and went back to her computer screen. There was no sign of cancellation. She called Vanguard again. This time, she says, she waited on the line for a long time, but no one came to take her call.

Meanwhile, Facebook stock opened at 11:30 a.m. The mysterious delay was due to technical glitches. NASDAQ's electronic trading platform couldn't handle the high volume of trades. In the first 30 seconds, around 82 million shares were exchanged.

Facebook did not experience the anticipated pop. The stock reached a high of around $45 per share. At 4:00 p.m., when the market closed, the stock was priced at $38.23, only 23 cents more than its opening price.

Later that day, the Wall Street Journalreported that Morgan Stanley had stepped in to stabilize the stock, using what is referred to in finance as a "greenshoe option" -- a common stipulation in the IPO agreement that lets underwriting banks sell more shares to investors than they are allotted. The mechanism lets banks buy back the shares at the offering price, in case the company's stock price needs a little help on the first day. The buying action puts upward pressure on the stock.

Her son came to New Jersey to stay with her over the weekend. For two days, they quarreled. He wanted to know why she put so much money into one stock, and she couldn't give him a satisfying answer. "He kept asking me what was going through my head when I bought the shares," she recounts.

On Monday morning, she called Vanguard. "Was my purchase cancelled?" she asked. The answer finally came: No, the broker told her, Vanguard had purchased 5,000 shares on her behalf at a price of $41.25, meaning about $206,000 from her retirement account was spent to acquire her stake.

On that second day of trading, Facebook closed at $34.03. Swaminathan had lost, on paper, about $36,000. Her son advised her to hold onto her shares until she either resolved the matter with Vanguard or the price bounced back.

VIII: THE AFTERMATH

The next couple days were a blur. Swaminathan approached Vanguard again, asking why the cancel order wasn't processed. She could have sold the shares before the price plummeted, she said to the broker, asking to speak with a supervisor. The supervisor blamed NASDAQ and said they would notify the exchange about the incident. When she called a day later, Vanguard declared it a legitimate purchase. There was nothing that could be done for her.

In the meantime, she tuned into CNBC to watch coverage of the IPO's aftermath. When news started rolling in about class action lawsuits filed against Morgan Stanley and Facebook for selective disclosure, she was stunned. Institutional investors received warnings about lower revenue estimates before the opening day, CNBC reported. (Some of these class-action lawsuits are still ongoing.)

Swaminathan wasn't keen on using the court system. She had already lost money and was wary about losing more to legal expenses. But in June, one lawyer told her about the Financial Industry Regulation Authority (FINRA) -- a private corporation that acts as a self-regulatory body among securities firms, such as banks. She believed the agency had a way for her to seek restitution without the complexities of a formal lawsuit. FINRA offered a way for her to air her grievances without a hefty legal fee, and the organization's stated goal is to protect investors -- investors like her, she thought.

She quickly wrote a typo-riddled complaint, laying out her misgivings against Facebook, Morgan Stanley, NASDAQ and her brokerage firm Vanguard, to FINRA. It was a two-page explanation of what happened on the day of the IPO. "I was caught up in the Facebook IPO hype and thought that this would be a good investment and practically put all my retirement money in this stock purchase," she wrote in the complaint. She said Vanguard failed to inform her of the status of her trade, blamed NASDAQ, and then retracted responsibility to say her trade was a proper execution. She complained that "only certain customers, mostly big institutions and hedge funds" could file claims with NASDAQ about the trading glitches.

She also jotted down the expected reparation: $105,000 for compensatory damages, $500,000 for punitive damages, $1 million for "pain and suffering" and $315,000 in damages related to fraud. "I feel jilted and my confidence is now permanently stricken," she said in the complaint. FINRA will be on my side, she thought, as she told her story to the regulatory body.

IX: THE HEADLINES

On July 16, FINRA sent Swaminathan a letter: Neither Facebook nor NASDAQ was a member of their organization, and it lacked the authority to call them in. Still, she was willing to arbitrate with Morgan Stanley and Vanguard.

But in November, a response came from Morgan Stanley in the form of a lawsuit: Morgan Stanley & Co. LLC v. Swaminathan. The bank had essentially filed an injunction to stop the arbitration from happening, requesting that Swaminathan pay legal fees incurred if it is required to participate in arbitration. When Swaminathan read the court documents, she panicked. "They wanted to take what I had left," she cried.

She was mortified. "Whatever happened to confidentiality?" she exclaimed. "FINRA had promised that my documents would stay private." Indeed, her complaint might have stayed private if it went unsettled (FINRA makes awards and judgments public on its website). But Morgan Stanley made her papers available to the press when it attached them to a countersuit filed through New York's public court system.

She eventually withdrew her claims against both the bank and Vanguard. "I just couldn't deal with the stress anymore," she said. "I guess the big guy always wins."

X: THE LOSS

An American flag hangs in front of the JPMorgan Chase tower in midtown Manhattan. In early May, rivaling its height was another banner with a Facebook IPO logo. Business journalist Heidi Moore shared a photograph of the building's façade with her Twitter followers on May 4. Radio reporter Ben Bergman retweeted it with a comment: "In Facebook We Trust."

By Aug. 18, Facebook lost about $50 billion in value. But many big investors made huge profits betting against the company, and others avoided major losses by backing out of the IPO just in time. During the roadshow, Capital Group, a large mutual fund and one of Morgan Stanley's preferred clients, pulled out of the deal after initially showing interest, and many other funds followed suit, according to a research analyst who was in correspondence with investors. SAC Capital Advisors, Steven Cohen's $14 billion dollar hedge fund and another one of Morgan Stanley's prominent clients, took a sizeable short position in the stock, said a research analyst. Scott Sweet's multi-billion dollar hedge fund client flipped the stock at $42. His subsequent short made his firm its "largest profit of the year," Sweet said. There's "no way" a retail investor could have known about the lowered projections, unless he or she "had a friend at a multi-billion dollar institution," he added.

A few days after Facebook debuted, Massachusetts's regulator William Galvin issued a subpoena to Morgan Stanley as part of an investigation into research analysts communicating Facebook's revenue prospects to certain institutional investors. Seven months later, Galvin's office settled with Morgan Stanley for $5 million after charging its investment banking division with inappropriately influencing research analysts during Facebook's IPO roadshow -- essentially breaching the "Chinese Wall." When asked about the script he wrote for Facebook's vice president of finance, Grimes testified, "I don't remember if she had a script or not."

Facebook, Vanguard, and Morgan Stanley declined to comment on all the claims in this story.

Swaminathan held onto her shares and went to her birth city of Chennai, India. She's writing two books -- one about herbs and spices and another about New Jersey's public school system. She hasn't traded stocks in a while, but she checks Facebook's stock price every few days hoping that someday it will bounce back.